There has been a lot of option activity in my retirement accounts recently so I wanted to take some time and explain how to calculate the return on investment (ROI) using a real example of a trade that I did yesterday. As you know, I am working on increasing the exposure that my portfolio has to dividend paying stocks. Well, one of the stocks that I was looking at was Nucor (NUE). I was able to purchase some shares using the proceeds that resulted from the exercise of ONXX $46 puts last week.
My goal is to get a 1% return per month on my retirement account on average. Part of this should come from the increased focus on dividends while the rest will come from capital gains and covered call premiums. I believe that this is an achievable goal on average, although there will be times when the value will fluctuate above or below that target.
So, here is what I did yesterday. I started by purchasing the June $32 strike put options for $0.49 per share. Then I picked up the stock itself for $34.70 and put in an order to sell the June $35 strike calls at $1.10. This was about 5 cents above the ask at the time, but I figured that given the normal daily volatility, it would get filled if NUE approached $34.90. This did occur so at the end of the day, this is what my basis looked like before commissions:
$34.70 for the stock + $0.49 for the puts – $1.10 for the calls = $34.09
So, $34.09 per share is the amount that I have in the stock. Now commissions can have a big impact upon return, and I always hate it when those aren’t figured into the equation. I keep an Excel spreadsheet and add them in automatically based upon cash in and cash of the account. When I add in commissions for trading, my basis becomes $34.15322 ($34.16) per share. This is the number I will use for the calculations, but it is a little cleaner to look at the numbers without when you are learning.
Return on Investment If Called
If NUE is at or above $35 per share on June 16, 2012, it will get called away. If that is the case, let’s calculate the ROI for these four weeks. The general formula is the amount of profit divided by the amount invested (basis) multiplied by 100 to express in a percentage and would look like this:
($35.00 – $34.16) (profit)/ $34.16 (amount invested) * 100 = 2.459%
This meets my criteria of gaining 1% in a month. But what if the stock does not increase and does not get called out?
ROI if Not Called
This is a little more difficult situation to calculate because you really don’t know if there will ultimately be any profit. This is where the 1% monthly criteria comes into play for me. I want the premium income itself to equal 1% of the basis. So in this case, I use the amount of price reduction of the stock price for my “profit” and the basis as the amount invested to make the equation look like this:
$34.70 (purchase price) – $34.16/ $34.16 * 100 = 1.58%
The Nucor trade meets my criteria for 1% monthly.
Now what happens if the stock drops like a rock. Obviously, these percentages mean nothing. But this is where tracking a basis over time becomes useful. Ultimately, if the stock drops below $32 rapidly, I will not be in any additional danger of loss since I own the put options. I can add additional shares to the position each time meeting the above criteria. Eventually, the stock will stabilize and the ‘ROI if called’ will get realized.
By managing the position and adding shares at lower prices, it is possible to not lose money on a declining stock and break even.
So, if one-third of my stock picks fall into each category, the overall net impact is that the 1% monthly target will be met on a portfolio wide basis. The fact that I am starting to work with dividend stocks should help to minimize the volatility. That is the goal anyway.
- Protecting Your Portfolio When Selling Put Options (grandpermonth.com)
- How to Make $1000 Per Month Selling Put Options (grandpermonth.com)
It is the third Friday of the month again which, for all practical purposes, means that today is options expiration! They actually expire tomorrow but since the market isn’t open tomorrow, today is the last day for trading with all the contracts getting exercised or expiring worthless on Saturday. Because it is expiration Friday, I need to spend part of the early afternoon looking over my positions and figuring out what I want to do for next month.
If you have spent any time at all reading this blog, you know that I hold individual stocks in my retirement accounts and use protective puts to help prevent major losses. This is a good strategy with one significant drawback. Puts cost money. If all I did was to pay out money each month on a stock that was moving sideways, I could easily lose quite a bit of any profits that I would make.
So, in order to offset the cost of the protective puts, I will sell covered calls against those same stocks that I own creating a collar. Now I may do this for all the shares or only some of the shares in order to capture some capital gains. It really depends on my optimism regarding the stock which boils down to a gut feeling. Lately, I have been inclined to remain a little on the cautious side. The stock market has rallied quite a bit over the past few months, so I am concerned that it might be due for a correction or at least some consolidation. But who really knows? I don’t which way the market is going so I try to at least get some benefit no matter what happens.
Action for Today
So the trades that I will be looking for today will be to purchase puts on Seadrill (SDRL), Silver-Wheaton (SLW), Onyx Pharmaceuticals (ONXX), Dryships (DRYS), and Intel (INTC). I also own AKS but the position is so small I haven’t worried about buying puts. I am wanting to get out of the stock and into Nucor which pays a higher dividend. I also own Seagate (STX) but purchased some March puts a few weeks ago after the big earnings spike locking in some nice positive gains. My basis is $20.86 per share and the puts are for $25 so no matter what happens, I will get a gain of over 25% guaranteed in only 4 months. I like trading when that happens.
Now I don’t want to spend too much buying the puts since I will have to sell some covered calls as well to pay for them. I won’t be able to with SDRL since I have already sold March calls. I will likely go with deep out-of-the money puts to protect me only from catastrophe. With SLW, I will keep the puts a little closer to the actual market price. The stock is volatile so I want the protection. ONXX will end up being closer since it has been trending downward. DRYS will be the 2.5 strike, and Intel will likely be a little farther away. I sold some calls today that were in-the-money since it seems like INTC has been range trading for the past few weeks. I am concerned that the market will be declining so INTC may go with it.
This is what my day will hold as far as stock market action is concerned. I have the day off, so will likely go to lunch at Chuck E. Cheese with my two youngest kids today. It is a nice treat that we like to enjoy every couple months. I might have to buy these puts before we go so I am not concerned with the time.
Have a great day, and enjoy the weekend. I will be doing some writing, hopefully.
Today’s post is the reason that I wanted to provide an explanation of a stock collar. That is because my favorite options trade of all time involves the use of the collar. If you missed that post or really don’t understand what a collar is, you should go back and read it. Otherwise, keep reading.
Now this trade is not mine. It would be great if it were, because then maybe I would own a professional sports team. Although I would have chosen football over basketball. Because this trade is not mine, I am having to go by news reports but the principles remain the same even though I can’t provide the minute details.
How to Save a Billion Dollars
I am sure that you have heard of Mark Cuban, the billionaire owner of the Dallas Mavaricks who won last year’s NBA Championship. I suspect that you may also know that Mark Cuban became a billionaire by helping to found and grow the company Broadcast.com with a partner, Todd Wagner in 1995. He ended up selling to Yahoo in 1999 for $5.7 billion in stock.
Now I am not sure where Mark Cuban came up with the idea, but it turned out to be brilliant. Again, investing in the rearview mirror is easy. It is managing investments in real time that is difficult. The 14.6 million Yahoo shares that Cuban had were valued at $95 each or almost $1.4 billion. That is a lot of wealth to be concentrated in one position so Mark Cuban ended up structuring a collar that allowed for some upside but limited risk of loss.
Here are the details of the trade:
- A total of 146,000 put contracts with a strike price of $85 per share were purchased. The cost of these were offset by
- The sale of 146,000 call contracts at a strike price of $205 per share (zero cost collar)
- Expiration was 3 years away
What this meant was that Cuban could more than double his money and take advantage of any rise in the stock price of Yahoo up to $205 per share but would only lose $146 million at most. He could still walk away with $1.2 billion even if the price of Yahoo cratered.
Well, it turns out that the price of Yahoo stock rose to $237 per share in January of 2000 which meant that the trade didn’t look all that smart. But as I have been learning in the stock market, it never pays to get greedy! That’s because a little over 2 years later in late 2002, the internet bubble had burst and Yahoo was trading at $13 per share. Brilliant!
The end result was that Mark Cuban managed to save himself $72 per share in lost wealth or just over $1 billion dollars. Now he was able to diversify into other investments.
Again, I cannot tell you exactly how he came up with the idea but obviously someone who knew how to protect capital and wealth felt that this particular collar trade was a good idea, and I would have to wholeheartedly agree. And that is why it is my favorite options trade of all time! Maybe someday, I can replace it with my own.
Readers: So what do you think? If you hadn’t heard of the collar, I doubt you would have heard that Mark Cuban managed to execute one with great effectiveness. But I bet you had heard of Mark Cuban! Feel free to comment below.